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The Buying Stampede: Like Lemmings Over a Cliff?

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Money coming into market isn't picking stocks on fundamentals - it just wants to be in stocks.

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My friend John told me something arcane, hard to interpret, but perhaps meaningful.

Index option prices have come way down. He measures it by "implied volatility." For example, with an SPX index option trading at a certain price, his model might say that the price implies at 30 volatility. This means the option price is implying that the index will move up or down 30% over the next year.

Now, an index option price is driven by 2 things: The volatility of all the underlying stocks and the correlation between those stocks. The first part is intuitive; the second is not.

Let's pretend an index has only 2 stocks in it: A and B. If A goes up and B goes down, they cancel each other out, and the index is unchanged. But if A and B go down together, the index moves a lot. So when the correlation is low between stocks, the index volatility tends to be low; when the correlation between stocks increases, the volatility of the index rises.

Based on the option prices of the underlying stocks as compared to the option price of the index, his model can measure the implied correlation between stocks.

He tells me statistically something is happening the degree of which is very rare. Even though the option prices and the implied volatility of the stocks has dropped a lot, the implied correlation has remained near all-time highs.

After saying "so what," he finally got to the punch line. This means that -- to a very great degree -- the money coming into the market (as it rises) is almost all coming in through equity index futures.

Even I know what that means: The money coming into the market isn't picking stocks on fundamentals, etc. It just wants to be in stocks.

You can make your own conclusions on that one.
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No positions in stocks mentioned.
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